July 17, 2013
Best Practices: Early Default Loans and the Guaranty Purchase Package-Underwriting Issues
by Starfield & Smith
When preparing a guaranty purchase package, Tab 7 must be completed only for “Early Default” loans. This will be the first of two articles discussing guaranty purchase requirements and issues related to Early Default loans. This article will discuss the underwriting-related requirements of Tab 7.
SOP 50 57 identifies the following events as providing the basis for an “Early Default”:
“1. Failure to make a scheduled loan payment;
2. Funding a scheduled loan payment from the sale of collateral rather than from business operations;
3. Deferment of more than three consecutive scheduled full payments; or
4. Any other event of default that required the loan to be classified in liquidation status, e.g., bankruptcy.”
Any such event is an Early Default when it occurs either (1) within 18 months of the initial disbursement, or (2) within 18 months of the final disbursement, if the final disbursement occurred more than 6 months after the initial disbursement, unless the borrower cures the default and makes scheduled loan payments for 12 consecutive months after the initial 18-month period. If the lender determines that a loan is an Early Default loan, it must address the requirements of Tab 7 of the SBA’s 7(a) 10 Tab package.
Unless the loan was made to fund a start-up, Tab 7 requires the lender to provide copies of the IRS tax transcripts, together with the financial information (e.g., financial statements) that the lender compared to the tax transcripts and relied upon in its credit analysis. Any discrepancies must be explained. The lender should review its credit memorandum; if it relied on unverified (such as compiled financial statements, in lieu of cash basis tax returns), the lender should explain why such financial information was relied upon, and why it made sense to do so.
If the defaulted loan was made under the lender’s PLP delegated authority, Tab 7 must also include the borrower’s application, the lender’s credit write-up, and documentation that the lender used and/or relied on to justify cash flow and loan approval. As this requirement, and that of the tax transcripts, suggests, the SBA will examine the lender’s underwriting for compliance with SBA requirements when the loan is an Early Default. Pursuant to SOP 50 57, a denial of the guaranty is likely to be justified if the lender’s underwriting was not prudent, e.g, if any of the following are discovered:
1. The Borrower’s projected expenses greatly exceeded projected revenues and the Borrower had no other source of income;
2. The Borrower was a startup business and the lender did not compare the Borrower’s projected revenue against an industry standard or another reliable measure, including the lender’s own experience making loans to similar businesses;
3. The cash flow analysis did not take into account an obvious fact that could easily affect the Borrower’s repayment ability, such as the owner’s monthly draw;
4. The cash flow analysis contained unjustified and overly optimistic revenue projections, (e.g., revenues projected to increase by 100% the first year when the industry standard is 25% maximum, without explanation for the difference); or
5. A material mathematical error in cash flow calculations, so that the loan would not have been made or would have been restructured so an Early Default would not have occurred.
The only stated basis for overcoming the likelihood of such a denial is the presentation of credible evidence that the business failed for “totally unrelated reasons” – a very high standard. If the lender’s credit memo is likely to raise underwriting concerns upon review by the SBA, it would be advisable to contemplate explanations that can be provided to the SBA to support that the lender’s underwriting was (1) compliant with SBA requirements and (2) otherwise prudent
For more information regarding guaranty purchase requirement, please contact Amy at 215.542.7070 or contact Amy at firstname.lastname@example.org.